Conventional Wisdom About Credit Default Swaps

I originally published this post over at The Hearing on Monday, but it feels more like a Baseline Scenario kind of post.

One part of the Obama Administration’s financial reform plan is tighter regulation of credit default swaps – those previously unregulated derivatives that brought down AIG and nearly the entire financial sector with it. One of the problems with AIG was that its regulators were apparently unaware that it had amassed a huge, one-sided portfolio of credit default swaps that amounted to a massive bet the economy would do just fine; another problem was that, because credit default swaps were “over the counter,” custom transactions between individual private parties, they created a large amount of counterparty risk – the risk that the party you were trading with might not be there to honor the trade.

In response, the administration proposes to “require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).” In addition, “regulated financial institutions should be encouraged to make greater use of regulated exchange-traded derivatives.” Major players in the market will also be subject to conservative capital requirements (making sure they have enough money in case their trades go badly) and reporting requirements. These provisions aim to increase regulatory oversight and minimize the chances that a derivatives dealer will fail and take its counterparties down with it, and as far as they go they are a good thing.

However, there is one potential loophole that, according to UCLA law professor Lynn Stout (on Friday’s Morning Edition), is “potentially big enough to put the state of Texas into.” The loophole is that “customized bilateral OTC derivatives transactions” would remain out of the reach of both exchanges and CCPs.

Custom derivatives would still have to be reported to regulators, so what’s the problem? The small problem is that unnecessary customization of financial products is a great way for derivatives dealers to jack up unnecessary transaction fees. The big problem is that custom derivatives are by their nature harder to oversee. Regulators want to be able to estimate a firm’s potential exposure across all its tranactions under various scenarios; the more complex those transactions, the more difficult this becomes. Regulators already had the power to demand access to banks’ books before the financial crisis; the problem was that they lacked the staff and skills to understand the complex structured products those banks were manufacturing and trading. As a result, custom products become a way for market participants to hide risks from oversight, and a potential means for systemic risks to build up out of sight.

The conventional wisdom is that some firms have unique needs and therefore there have to be customized derivatives contracts. But the real question to ask is why we need customized derivatives in the first place. For example, you can only buy U.S. Treasury bills and bonds that mature on specific dates, and in specific denominations (although perhaps there are banks that will custom-manufacture a Treasury-like security for you, and charge you a transaction fee – while throwing in counterparty risk for good measure). What’s wrong with a world where you can buy a credit default swap on any fixed-income instrument, but only for certain maturities (including the maturity of the underlying instrument) and on standard terms (such as the definition of a credit event and how the swap will be settled)?

I know the high-level answer (in fact, I already said it): firms have unique hedging needs. But I want to hear some good examples. On that same Morning Edition segment, Cory Strupp, a lobbyist at the Securities Industry and Financial Markets Association, gave this example: “If you have a company that wants to hedge a credit exposure in an odd amount of money – $156,217.25 – they can enter into a credit default swap that covers exactly that amount of credit risk, to the penny.” This is a terrible example, because if I’m a company of any size, and I have a credit exposure of $156,217.25 but I can only buy credit default swaps in multiples of $10,000, that’s perfectly fine with me. Strupp must know it’s a terrible example, but must have decided the better examples were too complicated for NPR.

And once we know what the good examples are – and I imagine there are some – the question is whether the benefits they provide to the parties involved outweigh their costs. And by costs, I don’t mean just the transaction costs; I mean the fact that customized derivatives make regulation harder and increase the risks of a costly failure. This is an externality, pure and simple, and it should be deterred or taxed.

(I’m guessing someone will point out that the Constitution limits the ability of the government to interfere in the freedom of contract. But remember, this is a regulated industry. Custom derivatives increase the cost of regulation; it would be perfectly constitutional to say that firms that trade in custom derivatives must pay a hefty tax on those products to offset the increased regulatory cost. If the tax is big enough, that would deter banks from using custom derivatives when standardized ones would do.)

There’s actually an interesting point behind this question. Someone – I think it was Felix Salmon, but now I’m not so sure – said that the real problem wasn’t that firms weren’t perfectly hedged; it’s that they believed they could be perfectly hedged. Risk never goes away; if you think you’ve eliminated it, it’s just gone someplace else to hide. Instead of a system where companies think they can hedge their risks perfectly because financial products are infinitely flexible – and therefore don’t manage their risks effectively – it would be better to have a system where companies can’t hedge their risks perfectly, and know that, and behave accordingly.

By James Kwak

37 responses to “Conventional Wisdom About Credit Default Swaps

  1. Pingback: friendsofdave's status on Thursday, 25-Jun-09 17:57:09 UTC - Identi.ca

  2. First step to properly regulating CDSs is understandable, tradable and non-customizable BASIS for any and all swaps. It’s impossible to evaluate (and therefore regulate) one-off bets based on guesses about the future value of some custom contract. When these guesses are aggregated, it becomes even more impossible. OTS had zero understanding of even the simplest elements of AIG’s book, let alone AIG’s inability to perform in total.

  3. There are certainly a lot of things about risk, hedging, and the benefits of derivatives that I don’t know. I fully confess that. But why should we risk the entire economy of our country, not to mention the ripple effects America’s economy has on other countries, so some very large companies can have a false sense that they’re eliminating risks. That’s assuming they even TRULY believe they’re eliminating risks.

    I think these “risks” are MANUFACTURED AND FABRICATED risks by banks/financial institutions in order to generate commissions or gamble the money of small depositors for their own profit. If they win guys like Joe Cassano take it all, if they lose “Joe taxpayer” gets left holding the bag.

    James Kwak and Simon Johnson are much much more knowledgeable than me. I appreciate the hard work the 2 of them do and all the insights they give the readers. I feel both of them are on the “front lines” of these issues for the consumers, small depositors, and taxpayers. But I must be honest and say that I’m a little disappointed that Mr. Kwak and Mr. Johnson haven’t stated an absolute abhorrence to these Credit Default Swaps. And when I say express an absolute abhorrence, I mean that Credit Default Swaps should be BANNED from the marketplace. BANNED—OUTLAWED—ILLEGAL–OFFICIALLY PROHIBITED.
    Pick whatever terminology you think sounds cool this week. It makes me sick and nauseated. You know what sound-minded people do when they want to “hedge” their risk??? They just don’t invest in things that they feel are risky enough to be hedged in the first place. Crazy huh???

    I like to think of myself as a broad-minded person who is always willing to learn new things. But the day I understand the necessity of Credit Default Swaps, please take me to the nearest insane asylum.

  4. sophie major

    Conventional wisdom is not always the truth and group think describes a subtle force in groups, like peer pressure, when members avoid disagreement with the group to prevent their own embarrassment, or to simply avoid confrontation.

    The advent of the television brought people inside their homes, away from their usual community interaction, and thus conditioned them to think that somehow what they saw on TV from their government was what they had to expect. The internet has somewhat changed that, since people are finding each other again, but still we are left with problems—conventional wisdom, and the group think associated with people’s need to fit in and not look stupid.

    Conventional wisdom and group think give a beginning explanation as to why so few people know that the Federal Reserve is a private corporation. Yes, the Federal Reserve Act gave this privately held corporation with 300 shareholders the right to print our country’s money, and to charge for doing so, and to rebate the United States Treasury for all profits minus their operating expenses.

    Bloomberg reported on June 5, 2009 in the article “ Fed Intends to Hire Lobbyist in Campaign to Buttress It’s Image” , that the Federal Reserve was hiring one of Enron’s previous lobbyists. On May 6, 2009, US representative Alan Grayson questioned the Inspector General of the Federal Reserve, Elizabeth Coleman, if she had any idea where 9 TRILLION dollars of off-balance sheet transactions for the Federal Reserve were located—she had no idea. Structured investment vehicles (SIV) were the method that Enron used to manage the off balance sheet transactions that caused so much hurt to so many people, and it is also, SIV’s that the Fed is using for this 9 trillion dollars. Since both the Federal Reserve and Enron use SIV’s, perhaps an x-Enron lobbyist will help the private Federal Reserve Corporation navigate the bad press that seems likely to follow, when the public understands these details.

    As of June 11, 2009, HR1207, the Federal Reserve Transparency Act, which calls for an audit of the private Federal Reserve Corporation, surpassed majority sponsorship in the US House of Representatives and is now set for hearings next month.

    The public deserves to know that the conventional wisdom about the Fed being a government agency, is just not true—the Federal Reserve is a private corporation, estimated to be worth 1.0 to 1.5 trillion dollars, with profits from seignorage being estimated at 50-200 billion dollars, and a 6% dividend from 1% of all member banks reserve requirements is received by the private Federal Reserve corporation as operating expense, it certainly is a profitable enterprise. It is one of the biggest monopolies in the world. Most importantly, with this kind of power, it really is a non-issue about the Federal Reserve maintaining independence—rather the more pertinent question that needs an answer is whether our elected officials have independence from this behemoth of a power source. The answer to this question will help separate conventional wisdom from truth, and prevent group think (the ‘ not bucking conventional wisdom’ group) from allowing US citizens to honestly respond to the truth.

  5. I don’t think there there is going to be much of a constitutional argument to made against this kind of regulation. The general welfare and interstate commerce clauses should cover all of that just fine, and although conservatives have argued against their broad application, this seems like a reasonable basis for their use, for once.

    Felix Salmon has a good point; no one is perfectly hedged unless they’re out of the market. But there is an incentive to try to hedge better than the next guy. Regulation that limits the types of securities allowed isn’t going to matter much to the people who are trying to hedge, especially if their competitors are limited as well. It’s the people who create them, and charge huge fees for specialized instruments that will scream the loudest.

    Those are your two big problems with complex derivatives. They make effective regulation impossible, and they actually increase risk by substituting for better information and judgement.

    If institutions truly believe that they can simply hedge away all their risk in a transaction, then there really is no need to ever no anything about your counter-parties or the assets you are trading. And this is what has happened; institutions bought toxic assets and didn’t know or care because they thought they had them hedged. (As it turned out, a lot of them did; the taxpayer turned out to be a pretty good backstop.)

    Another way of looking at it is this; if i have very good, very reliable information, I really only need to hedge against systemic failure. And the less information I have, the more I need to hedge. But the other side of that coin is that if i think I can hedge perfectly, I don’t care about the information. And that is not conducive to an efficient market.

    With hedging, the perfect is indeed the enemy of the good.

  6. DesolationRow

    Again, this sounds like this administration’s attempt to sound tough on regulation but really, it gives the banks enough of a loophole to help them earn their way out of their capital holes. I actually truly believe the Fed understands the risks of CDS now and will regulate vanilla and custom derivatives equally. However, with “customizing” comes additional fees. Your line: “The small problem is that unnecessary customization of financial products is a great way for derivatives dealers to jack up unnecessary transaction fees.” sums it up pretty well. Also, with most likely a small core set of companies ultimately handling the majority of custom derivatives, collusion won’t be far behind.

  7. Single name CDS and indexed CDS are pretty much the only contracts that can be standardized. The structured products (CDOS, ABS), by definition, require customization. I’m not saying they are worthy products, maybe they are evil, but a synthetic CDO implies customization (writing protection on tranches that aren’t going to be cleared by an exchange/CH). But this is not unique to credit derivatives. There is a trade-off between liquidity and basis risk; e.g, in cat bonds, you can insure against the “standard” (index) or against the particular risk (indemnified). Even in commodities, the better the hedge you seek, pretty much the more you need a forward rather than an exhchange-traded future. I think your argument is almost upside-down, in the sense, one could argue, customized credit derivatives are the true hedge instrument (abuses notwithstanding, of course….) whereas the price discovery of a trading platform does not seem to limit speculation. Collaterlizing these instruments is a separate matter, I just don’t see an exchange/CCP as a special solution to the specific problems. Put another way, if AIG had to collateralize properly, I don’t think the fact they were OTC bilateral contracts would have been an issue. I think the problem has been mis-diagnosed.

  8. Mr. Kwak,
    Thank you for reposting this – I wasn’t able to reply over at The Hearing.
    While it’s tough to come to the defense of unregulated derivatives in the wake of AIG, I still feel justified in taking issue with elements of your essay.
    Firstly, CDS are conflated with the broader derivatives category within your text. This is a big error. A tremendous volume, and the vast majority, of OTC derivatives business conducted at investment banks (at least the ones that I study, in Europe) is in Interest Rate Swaps.
    Secondly, one must take issue with your suggestion that there is a large category of market activity that provides no value to the customers (exists only to generate “unnecessary transaction fees”). Are you of the view that the financial sector is an un-competitive one, and that its customers do not act in their own self interest? Some fundamentals have gone missing in this formulation.
    Your argument against the need for customized arrangement is nearly undermined by your invocation of the comfortingly simple-by-comparison Treasury market. Consider that a hedge might be required on any number of components of the debt capital structure of any number of firms, in a variety of currencies, in any amount, and for any length of time, and you might see a distinction to Treasuries. When you advocate that standardized CDS terms could be applied to “any fixed-income instrument” one can’t help feel that you are glossing over the wide variety of terms & conditions and structures that can exist across such instruments, all of which are factors that need to be accounted for in the CDS contract. The idea of standardizing all of this and posting it to an exchange sounds nice until you realize how very thin – to non-existent – the markets would be for trading in most of these “standardized” CDS. This is why it makes sense for the seller of protection to enter in to a custom deal which suits the client, and then go about the job of mitigating the risks just assumed, something which the seller (probably an I-bank) is very likely to be better suited to doing than the client would be (perhaps there is some value provided to the client, after all…?).
    Lastly, and – I apologize – most sniffingly, you seem to use your own ignorance about this market as part of your case against it, a tactic which weakens your case substantially. Perhaps there are experienced professionals in this area who would be willing to be interviewed for the benefit of the blog? Surely there are a fair number without much else to do, lately.

  9. “There’s actually an interesting point behind this question. Someone – I think it was Felix Salmon, but now I’m not so sure – said that the real problem wasn’t that firms weren’t perfectly hedged; it’s that they believed they could be perfectly hedged.”

    Maybe I got things wrong. I thought that the real problem, that is, the massive problem, was making side bets with CDSs. If somebody actually owes you money, then what is wrong with tailoring a hedge with an over the counter derivative?

  10. strike three

    Why?

    Obama is a wuss, and Geithner and Sommers are in bed with the ones that stand to reap gazillions. Remember, they are too big to fail.

  11. Obe-Wan Kenobie

    Ummm, you kind of forget that all this great derivative and hedging work you have been doing has amounted to a steaming pile of financial crap that did nothing for clients or shareholders, just you and your firm scamming fees. But thanks for asking.

  12. I agree with you. Truthfully, I’m not even convinced any companies should be “public.” So you can imagine what I think of gamblin’ games the boys make up in their cushy back rooms.

  13. James,

    In your first paragraph it sounds like the damage from CDSs is mostly done for this crisis. If this is likely to be true then I could sleep better. I have heard $30 trillion and up exposure from CDS. Are we really past the worst of it?

    Thanks for all your hard work.

    Ron

  14. What most bothers me, is that we don’t have a national insurance regulator, which allows things like CDS’s to go completely unregulated, and which allows for infinite arbitrage of complex insurance (and insurance-like) contracts. CDS’s are a plain and simple, complex form of insurance. At the very least, a national regulator could require the holding of sufficient reserves (as with all other forms of insurance) to adequately cushion any losses. But, this is just a small slice of the core of the problem with complex financial contracts. It is nearly impossible to determine (quantify) the potential risks because the roots of failure are distributed into so many nooks and crannies, and if each contract is hundreds of pages, how can any regulator effectively work with them. As I said in my response to yesterday’s CITI blog, we need to simplify and make transparent all financial transactions and markets (invoke a new Glass-Steagall and outlaw complex derivatives). Sorry, the present situation just points out the flaws of having too many attorneys structuring instruments in an era of completely amoral greed.

    That’s my latest Church Lady rant, take it or leave it.

  15. Ultimately CDS are simply financial engineering created for the simple purpose of increasing leverage- in other words we are talking gambling casino here. Anyone who thinks otherwise has been duped or is addicted. I have listened and read many defenses of the CDS market and have yet to find anyone who doesn’t talk or write like an addict. They can pull the most sophisticated BS out of their a$$ and make it sound like a doctoral dissertation but it is still BS. The only sane thing to do is shut the CDS market down but unfortunately the present combination of greed and madness trumps all in this time and place.

  16. One last point I forgot. By the way, everybody, who, other than the big traders, actually made money investing in this steaming pile of derivatives? From everything we hear, the guys who aren’t on the Street anymore (say Lehman, Bear Stearns, et al) are probably chuckling right now, because before the whole thing became a cluster ____, they placed their money neatly in offshore accounts, and waited for everything to fall apart. I presume that some of the current run up in the Dow has been fueled by them and their buddy’s “churning” for commissions and prepping for the next round after the regulatory smoke clears. Welcome to our world. These same folks will have been the sponsors of our drowning planet, and years from now their dying heirs will extol their amazing scams.

  17. Mary Fricker

    To see an example of how “custom products become a way for market participants to hide risks from oversight, and a potential means for systemic risks to build up out of sight,” read “Wall Street Wizardry Amplified Credit Crisis, A CDO Called Norma Left ‘Hairball of Risk’; Tailored by Merrill,” by Carrick Mollenkamp and Serena Ng, Wall Street Journal, Dec. 27, 2007.

  18. Do CDS produce any industrial or manufacturing jobs? How about retail? How about farming or any food producing jobs?

  19. sophie major

    The Church lady rules!

  20. “The conventional wisdom is that some firms have unique needs and therefore there have to be customized derivatives contracts.” Why would firms ever get into the position of needing customized derivatives contracts if such contracts were not available?

  21. sophie major

    other and their agents who chuckle: aka PPT (plung protection team)

    Executive Order 12631–Working Group on Financial Markets

    Source: The provisions of Executive Order 12631 of Mar. 18, 1988, appear at 53 FR 9421, 3 CFR, 1988 Comp., p. 559, unless otherwise noted.

    By virtue of the authority vested in me as President by the Constitution and laws of the United States of America, and in order to establish a Working Group on Financial Markets, it is hereby ordered as follows:

    Section 1. Establishment. (a) There is hereby established a Working Group on Financial Markets (Working Group). The Working Group shall be composed of:
    (1) the Secretary of the Treasury, or his designee;
    (2) the Chairman of the Board of Governors of the Federal Reserve System, or his designee;
    (3) the Chairman of the Securities and Exchange Commission, or his designee; and
    (4) the Chairman of the Commodity Futures Trading Commission, or her designee.
    (b) The Secretary of the Treasury, or his designee, shall be the Chairman of the Working Group.
    Sec. 2. Purposes and Functions. (a) Recognizing the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation’s financial markets and maintaining investor confidence, the Working Group shall identify and consider:
    (1) the major issues raised by the numerous studies on the events in the financial markets surrounding October 19, 1987, and any of those recommendations that have the potential to achieve the goals noted above; and
    (2) the actions, including governmental actions under existing laws and regulations (such as policy coordination and contingency planning), that are appropriate to carry out these recommendations.
    (b) The Working Group shall consult, as appropriate, with representatives of the various exchanges, clearinghouses, self-regulatory bodies, and with major market participants to determine private sector solutions wherever possible.
    (c) The Working Group shall report to the President initially within 60 days (and periodically thereafter) on its progress and, if appropriate, its views on any recommended legislative changes.
    Sec. 3. Administration. (a) The heads of Executive departments, agencies, and independent instrumentalities shall, to the extent permitted by law, provide the Working Group such information as it may require for the purpose of carrying out this Order.
    (b) Members of the Working Group shall serve without additional compensation for their work on the Working Group.
    (c) To the extent permitted by law and subject to the availability of funds therefore, the Department of the Treasury shall provide the Working Group with such administrative and support services as may be necessary for the performance of its functions.

    source: http://www.archives.gov/federal-register/codification/executive-order/12631.html

  22. Considering that a key theme of the original posting was value for the client (or lack thereof) provided by these derivatives, let’s keep in mind that the CDS written by AIG ultimately provided massive value to the clients. It is extremely doubtful that those clients begrudge AIG whatever fees it may have earned on the deals.

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  24. Mbuna- this is not really a reply- I’m just piling on from your comment.

    This is from Chris Whalen posted at Market Ticker:

    In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.

    The clear version of the above, in English.

    To put this in “Joe Six Pack” speak this “market” is exactly like playing Blackjack against a dealer who has a supply of aces and kings under the table, and uses them to deal blackjacks to himself any time he would like.

    Would you knowingly sit at such a table?

    It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.

    And let’s not forget who gets all the money. JP Morgan, Goldman, et.al.

    Seen in this context, AIG was the most visible “sucker” identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.

  25. Twotenths:”It is extremely doubtful that those clients begrudge AIG whatever fees it may have earned on the deals.”

    Especially since Paulson funneled taxpayer money through AIG to pay them off.

  26. There is no Constitutional difficulty w these proposed regulations because there is no Constitutional guarantee of “freedom of contract” and Art.I , Sec. 10, clause 1 regarding “impairment of contracts” applies to State governments not the Federal gov.

  27. The fundamental point, which James points out, is that risk can’t be eliminated unless return is eliminated, too. It may be (logically) possible within current market theory to hedge perfectly, but, the cost of hedging perfectly would eliminate all returns. Market participants can accept this principal while believing that different participants will evaluate a given risk in a specific situation differently or that some information asymmetry will give one party the ability to take advantage of the other party, i. e., that the market isn’t efficient. Some fool will sell you $1M of life insurance two weeks before you die of cancer for $100,000 (trusting the conclusions of examinations by Dr. Standard or Dr. Poor that you don’t have cancer, say). Thus, AIG sold $13B worth of risk insurance to Goldman Sachs for some price (which I don’t know).

    Twotenths’ last comment in his first post is key. The seller of insurance must add value to the transaction by some ability to mitigate the buyer’s risk better than the buyer (Twotenth’s client). He has not explained in any satisfactory way, nor has any other participant in this market, how the party who assumes the risks in my contract can mitigate them better or more cheaply than I. I take the collapse of this market to be overwhelming evidence that no such explanation exists because this abiity is illusory. This game is essentially a game of Old Maid with several Old Maid cards. When it stopped, Bear, Lehman and AIG (among others) were left holding the Old Maid.

    chas asks good questions – how is this game productive for anyone but the dealers?

  28. Michael Donner

    two obvious things that should be done immediately: 1. no CDSs unless you have an active, real interest in the underlying issue 2. no trading of CDSs.

    these two simple changes, that could be done immediately would increase our/my financial security right away.
    Michael

  29. sophie major

    Bravo Min!

    The thugs make their bets with the bookie AIG, then paulson says, don’t worry, the US Taxpayers will pay the bill because winning that massive value is the only way the world wont end as we know it–how bout good old fashion bankruptcy, unemployment, suffering—instead, the whole US is at risk for this massive devaluation of our currency.

  30. I don’t think it is only “for the simple purpose of increasing leverage”, I think there’s an even more basic driving force underlying financial innovations. The banks have so much money they need to invent places to put it. I’m serious here. Think of the amount of money in play, and then think of where else it could be legally invested without overwhelming that investment vehicle. It also explains the incredible rise in banking compensation over the last 10 years–they have too much money to find investments for, so they get rid of it.

    So I agree with you that it is a “gambling casino”, but it is also a holding pen for money.

  31. You are absolutely right. Commercial risks are uninsurable. Period.
    Ask yourself whether you could, as a business owner, insure your profits, or losses (on pure commercial gounds). I you think you can, ask then any conventional insurer whether he would cover you. If he did, he would be sitting now in jail.

  32. Benedict@Large

    If a CDS cannot be written in a form that allows for exchange trading, it is almost certain that its basis is unpricable without prohititive costs to do so (if even then). As such, any attempt at price discovery is nothing more than a wild guess, regardless of what sort of sophisticated model you can pay a quant to apply. Another word for this kind of guessing is gambling.

    Much is made of how the financial industry has soared in size relative to the rest of the economy, but this fact is not often equated to the massive increase in derivatives transaction fees and most especially CDS fees. When these two facts are looked at in concunction, it becomes clear that what we’ve done is allow casino economics to overwhelm our banking system. While this may be nice for the croupieres with their multimillion dollar annual bonuses, it’s effects on the rest of us have now become excrutiatingly obvious.

    Whatever limited benefits the supporters of these transactions might claim they have, the externalities created by them have become a huge unfair tax on the rest of us; a tax yielding insufficient (if any) benefit, and a tax unapproved in advance by our legislatures. (Taxation without representation, if you will.) As such, they must be banned from our financial system and from any participating institutions in it. If people still want to enter into these contracts, fine, but they must do so with the crystal clear understanding that there will be no government oversight and NO GOVERNMENT AID in the event of couterparty default.

    [For more on this, see Chris Whalen’s prepared statement to the Senate Banking Committee, June 22, 2009: http://www.ritholtz.com/blog/2009/06/over-the-counter-derivatives-modernizing-oversight-to-increase-transparency-and-reduce-risks/ ]

  33. Whoops, too many responses. Anyway – The issue to me is that you don’t need to solve the CDS problem for all time. Regulate per the O team. For customized derivatives, report ‘em as provided. The reportee adds up the notional values. If at some point the total gets to, say, 1X GDP (or, 2X?), then, bang, the SEC is now regulating them, and makes a few general statements such as capital requirements and etc. Anyone found to be in violation, ever, goes to the slammer.

    I call it the Duck Law* – if it looks like a security and behaves substantially like a security, then it is de jure a security.

    /b
    *http://vituscapital.blogspot.com/2008/10/venal-bastards-on-wall-street.html

  34. Dirk van Dijk

    Ok this is probably a dead thread, but the best way to think about CDS’s is that they are life insurance policies but on companies instead of individuals. In life insurance you have to have an insurable interest to take out a policy. In other words you can insure yourself, your spouse, maybe a business partner, but that is about it. You cant wander the halls of the nursing home and decide, old Mrs. Murphy doesnt look so hot, I’ll take out a policy on her. And if you are a cardiac surgon, you are not allowed to take out a policy on the guy about to go under your knife. Require an absolute insuable interest before a CDS can be written and allow no more than that amount to be insured. In other words, to have a CDS on a company you have to own the bond. If you sell the bond, the CDS policy becomes null and void.

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  37. Check this out:

    http://online.wsj.com/article/SB124718445317920379.html

    Big Companies Go to Washington to Fight Regulations on Fancy Derivatives

    This article illustrates very clearly something that has been missing from a lot of commentary here: These products which serve no valid puropse, according to critics, have a lot of customers. Probably not all of whom are foolish. Maybe someone could ask these firms why they are so willing to be ripped off by overly complex instruments that provide poor value?